Transcript 24 Balance of PAyments

HL Balance of Payments
IB Economics
The consequences of a current account deficit
If the current account is in deficit then the capital account will
have to be in surplus to balance out the deficit
This means one of three things will have to happen
1.Foreign exchange reserves may be used to increase the
capital account
However, no country is able to fund long term current
account deficits with reserves – eventually they will run out
2.It may be that a high level of foreign buying of assets for
ownership is financing the deficit
Foreign investors may be buying property, businesses, or
stocks and shares
If it is based on foreign confidence in the domestic
economy then this is not a problem
This is sometimes viewed as a threat to sovereignty
If there is a drop in confidence they move these assets to
other countries
They could sell their assets resulting in an increase in the
supply of the currency and a fall in its value
3.It may be that it is financed by high levels of lending abroad
High rates of interest will have to be paid
If governments lending the money decided to withdraw it
this would lead to a massive selling of currency and a sharp
fall in the exchange rate
The consequences of a current
account surplus
If the current account is in surplus
there will be other consequences
1.Allows a country to have a deficit on its
capital account by building up its official
reserve account or by purchasing assets
abroad
However, one country’s surplus is
another’s deficit and this may lead to
protectionism by other countries
2.It will usually lead to an appreciation of
the currency on the foreign exchange
market as it implies an increase in
demand for the currency
This will make imports cheaper so
reducing inflationary pressures
It will also make exports more
expensive harming exporters
How big is a ‘big’ current account deficit
or surplus?
There are two ways to interpret the size
of a country’s deficit or surplus
Total value
Or as a proportion of GDP
This is like having an overdraft on your
bank account
If you earn $100,000 and you have a $10,000
overdraft this is manageable
If you earn $30,000 and have a $10,000
overdraft you may be in trouble
Big is only bad if you can’t pay it back
Methods of correcting a persistent
current account deficit
There are two types of policy used to
correct a persistent current account deficit
Expenditure-switching policies
If successful imports will fall and the
current account deficit should improve
Examples
Depreciating or devaluing the currency –
exports will become cheaper and imports more
expensive
It depends how responsive domestic and
foreign buyers are to the price change but the
deficit should improve
Protectionist measures – restricting foreign
imports will make domestic consumers switch
spending from imports to domestic goods
Evaluation
Governments are often reluctant to use such
measures because it may lead to retaliation and
could be against WTO measures
Protecting domestic industries may also may
them inefficient in the long run
Expenditure
switching policies
– attempt to reduce
spending on
imports towards
domestic goods
and services
Methods of correcting a persistent current
account deficit
Expenditure-reducing policies
Deflating the economy may reduce the current account
but it is likely to lead to a fall in domestic employment and
a fall in the rate of economic growth
Examples
Deflationary fiscal policy
increasing taxes and/or reducing government
spending which will be politically unpopular
Deflationary monetary policies
increasing the rate of interest and/reducing money
supply
Hot money would flow into the country’s capital
account helping offset the deficit in the current
account
Politically unpopular because payments on
mortgages, loans and credit cards will increase
Investment may decrease
Overall
The economic costs of reducing a large current
account deficit suggest why it is important to prevent
it from happening
Governments will actively pursue export promotion
policies – trade missions, govt advertising campaigns
Expenditure
reducing policies
– attempt to reduce
overall spending in
the economy
(shifting AD to the
left)
The Marshall Lerner Condition
In theory when a country’s currency
depreciates its exports will be
cheaper and there will be an increase
leading to an increase in the current
account
This is not necessarily the case
How much the price change has an
effect on the demand depends on the
PED of imports and exports
The Marshall-Lerner condition is a
rule that tells us how successful a
depreciation or devaluation of a
currency’s exchange rate will be
If the demand for exports was
inelastic and the price fell there
proportionate increase in demand
would be less than the proportionate
decrease in price
The same for imports
Complete student workpoint 24.3
Marshall-Lerner condition –
reducing the value of the
exchange rate will only be
successful if the total value of
the PED for exports and the
PED for imports is greater than
one
PEDexports + PEDimports > 1
The Marshall Lerner Condition
The table below shows a study of trade
elasticities in 2000
In almost all cases the short run values were
lower than the long run values
This is to be expected because PED become
more elastic over time (ability to look for
alternatives)
Only the US would meet the Marshall Lerner
condition in the short run but all meet the
condition in the long run
Marshall-Lerner
condition –
reducing the value
of the exchange
rate will only be
successful if the
total value of the
PED for exports
and the PED for
imports is greater
than one
PEDexports +
PEDimports > 1
The J-Curve effect
 In the short term a depreciation of the exchange rate
may not improve the current account deficit of the
balance of payments
 This is due to the low price elasticity of demand for
imports and exports in the immediate aftermath of an
exchange rate change
 Initially the volume of imports will remain steady partly
because contracts for imported goods will have been
signed
 However, depreciation raises the sterling price of
imports (that will also remain steady due to contracts
with suppliers) causing total spending on imports to
rise
 Export demand will also be inelastic in response to the
exchange rate change in the short term
 Therefore the earnings from exports may be
insufficient to compensate for higher spending on
imports
 The balance of trade may worsen (X to Y) in the
immediate aftermath of a fall in the external value of
the currency
 This is widely known as the J-Curve effect as seen in
the diagram
 The PED for exports and imports increases with time
until it meets the Marshall-Lerner condition and
satisfied leading to a movement from Y to Z
Time for you to do some work!!
At home read through the chapter (make
notes if you wish)
SL - Complete Exam Q’s 1 & 2 on P307
HL – complete 2 x HL Exam Q’s on P307